Bouts of financial market volatility likely to return

Markets have calmed recently, following sharp losses in the first two months of 2016. Depending on the region and market, much or all of the year’s losses have been regained. The US S&P 500 is back in the black year to date and commodities prices are trending up modestly. This rebound makes sense to us. Markets over-reacted to signs of slowing growth, with prices moving to levels instead consistent with a recession.

But further volatility is likely, not least because threats to global growth haven’t receded. Global GDP growth totaled only 3.0% in 2015 and forecasts for 2016 have been revised lower. Although recent US jobs gains have been encouraging, and European high-frequency indicators have exceeded expectations, these data are backward looking. Confidence in the state of the global economy remains shaky.

Now vs. the GFC

Comparisons between the turmoil in January and February versus the GFC in 2009 yield a number of observations.

On the encouraging side:

Stronger consumer. Consumer balance sheets are much stronger than they were leading up to the GFC. Lending standards have been higher and home mortgage LTVs are lower. Underwater households have, by now, mostly defaulted or deleveraged.

Less favorable observations include:

Fewer traditional tools for Central Banks. Central banks are now closer to or beyond the “zero bound” of interest rates and have already expanded their balance sheets dramatically. As such, they are low on conventional monetary policy ammunition to fight a recession.

Monetary policy moving into uncharted territory

One likely cause of volatility will be the evolving monetary-policy environment. In particular, the outlook for US interest rates has been a moving target, with expectations for rate rises waxing and waning with market movements and inflation indicators. Elsewhere, the focus is less on the direction of policy than the unconventional nature of the toolkit. In a low interest rate world, some have worried that central banks are “running out of tools”. This is clearly not the case. Six central banks, including the ECB and the BoJ, have already moved to negative interest rates. Once considered practically unthinkable, negative rates are intended to stimulate growth by forcing banks to make loans, but they may weigh on bank profitability and cause other unintended distortions. Just as negative rates rapidly moved from textbook theory to status quo, other ideas such as “helicopter money” are gaining traction and have an increasing chance of implementation. These strategies may or may not be effective; this very uncertainty will contribute to volatility.

Governments won’t step in where central banks leave off

In the absence of a steadying influence from central banks, it might be hoped that structural reform and targeted fiscal policy would help rescue global growth prospects. But the rising tide of populism in many regions, driven by legitimate concerns over migration, terrorism, and inequality, will make smart policymaking challenging. From Brexit to the divisive US presidential primary to the veritable alphabet soup of insurgent and upstart political parties in Europe, political risks abound. Events such as the tragic attacks in Brussels only exacerbate tensions and therefore uncertainty, even if their direct economic impact is likely to be limited.

Mixed impact on real estate

The impact of slowing growth and volatility on real estate pricing will be mixed. Investors may elect to move out of risky assets into safe havens. But at the same time, real estate continues to offer attractive current income and its status as a hard asset holds wide appeal. The “yield cushion” between government bond yields and cap rates—oft cited as support for cap rate compression and a reason not to worry about rising rates—still exists and may actually be widening in markets where monetary policy will remain accommodative.

One performance differentiator will be the ability to identify safe haven sectors/markets

But some of the yield cushion may now represent an increased risk premium. As with corporate bonds, where the riskier end of the market has seen weakness expand beyond the energy sector, the size of this risk premium will depend on property type, location, and risk characteristics. Further yield compression could occur for the best properties and markets. One performance differentiator will be the ability to identify safe haven sectors/markets such as self-storage that are likely to benefit from their proven resilience versus those like City of London offices, that are in a later phase of their rental cycles.

US

Slow economic growth to continue

Outside of estimates for Q1 GDP, which show even slower growth than the revised figure of 1.4% for Q4, recent economic releases position the US for gains in line with recent years. The acceleration in wage growth in March could prompt better consumer spending. The Fed, meanwhile, has to navigate a tricky environment in which inflation has accelerated to close to its 2% threshold. A rate rise was put off in March and it’s highly unlikely that the Fed will hit its previous plan for four rate hikes in 2016. But managing inflation is a central component of the Fed’s mandate. How to do this without unleashing another bout of global market volatility? Stay tuned.

Prices will diverge

Capital markets demand for real estate was strong in 2015 with transaction volume matching the 2007 peak. As fears of a market correction have escalated, investors have turned to caution. Many plan to be net sellers in 2016. This will translate into more properties on the market and yields could rise for less-desirable assets. As the economic environment settles, and financial markets stabilize, capital deployment is likely to continue at close to its prior trajectory.

Apartment rents have peaked, as expected, but other property types appear poised for rising occupancy and rents.

Fundamentals supported by unusually low development

Property market conditions vary by sector, but fundamentals continue to be supported by a financial and regulatory environment that has constrained development outside of apartments and industrial. Apartment rents have peaked, as expected, but other property types appear poised for rising occupancy and rents. Tenant demand for high-quality retail remains strong, and the case for self-storage and the other specialty property types is intact.

Europe

Vulnerable to global storm clouds

Unlike earlier turbulent episodes since the GFC, market volatility in Europe this time around is largely not home-grown but tied to broader global themes. European GDP growth was surprisingly good in 2015. Unlike the US, evidence exists that European consumers were mostly spending, not saving, their gas pump windfall. And, after years of lagging North America, real estate rent and NOI growth finally started to materialize in a broader range of markets than just Central London. Absent global challenges, prospects for 2016 seem pretty solid.

That said, immunity from today’s challenges is not in the cards. Europe’s potential GDP growth is already low due to structural and demographic limitations. With slowing global growth translating into tapering European growth (which is becoming increasingly clear in the high-frequency indicators), Europe will clearly be vulnerable as its growth rates are already close to “stall speed”. We were wrong in expecting a big boost to quantitative easing by the ECB at their December 2015 meeting, but only in timing. The ECB went big in early March, announcing an aggressive package, including cutting rates further into negative territory, stepping up the pace of quantitative easing, and providing banks with “cheaper than free” funds.

Brexit is the most significant risk that is uniquely European

The most important source of volatility emanating from within Europe is the Brexit vote, now likely to occur in the summer of 2016. Polls are close, and a result that prompts the U.K. to leave the EU would have an unambiguously negative impact on U.K. growth and office demand, particularly in London submarkets exposed to financial firms (which rely on EU passporting to do business on the continent). Great uncertainty would surround the unwind of and future for the U.K.’s relationship with Europe.

Asset selection with structural and secular themes

Given the vulnerability of Europe’s cyclical growth, we continue to advocate for exposure to structural and secular themes that would continue even if cyclical growth were to cease. Sectors offering investment opportunities that benefit from such demographic and societal trends include rented residential, student housing, and senior housing.

Asia-Pacific

New growth model in China

The cloud cast by China’s attempts at economic transformation will take time to dissipate, affecting countries within the Asia-Pacific and beyond. China’s days of economic growth in excess of 8% are now over as its leaders steer away from the old investment and export growth model in favor of markets, consumers, and services. While growth remains impressive by global standards, the government wants a greener expansion with slower debt growth as it tries to liberalize its capital markets and currency. As such, in its latest Five-Year plan, the government is now touting growth of 6.5% to 7%.

Australia surprises

With the slowdown of its largest trading partner, China, the Australian economy experienced slower expansion of 0.6% (q-o-q). But real growth for 2015, at 2.5%, surpassed expectations, helped by rising consumption, which offset falling fixed capital formation. Labor conditions have firmed with February’s unemployment rate at 5.8% from 6.0% in January. The Reserve Bank of Australia kept the official cash rate at a record-low of 2.0%.

Japan adopts negative rates

The Bank of Japan instituted a negative interest rate regime for funds on deposit in late January, a clear sign that inflationary pressures remain weak. Negative rates will likely push domestic Japanese banks into further lending, which should, in turn, make mortgage pricing more competitive and sustain real estate pricing. Loose policy and low funding costs should restrain any dramatic movements in real estate yields unless the turbulence in financial markets substantially reduces liquidity.

Volatility in FX

In late 2015, we identified the risk of downward pressure on the Chinese renminbi versus the dollar for 2016 and see little reason to adjust that expectation. We also observed that the modest appreciation could occur in the Japanese YEN. We did not, however, expect such sharp appreciation. Similarly, efforts by the RBA to talk down the Australian dollar have been limited. Having said that, the Australian economy continues to hum along, entering its 25th year without a recession.

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